Living on a Budget

Q-and-A With Jonathan D. Pond: Annuities and Retirement Saving

The company I work for is stopping their defined benefit retirement plan and the payout will be this October. The options are either a lump sum settlement or an annuity. I know there are advantages and disadvantages to both options. An annuity, even with a "safe company," may disappear if the company goes out of business, as some have done recently. I have over 30 years in this plan, and I need to make an informed decision that will last me and my wife the next 30 years or more. –Dan, Georgia

The decision between taking an income annuity and a lump sum affects almost everyone who is about to retire or who has retired recently. Anyone who has any money set aside for retirement can choose to put it into an annuity. This is a very important decision. If you choose the annuity route, you’ll probably have to live with that decision the rest of your life. Before delving into the nitty-gritty of annuities, keep the following in mind:

Nothing in your financial life is “either/or.” A lot of people think that most of their financial decisions are "either/or" decisions. In other words, when confronted with a financial choice, most people think they must either take one course of action or the other.

But most financial decisions don't require you to do either one thing or the other. Often, a combination is more appropriate, and so it is with your decision. Perhaps a combination of an income annuity for part of the payout and a lump sum for the rest is the better course of action.

These questions can help you decide whether an income annuity should be part of your financial planning.

1. Are you uncomfortable investing your retirement savings in the stock market? Fixed-income annuities and inflation-adjusted income annuities alleviate any concerns about possibly losing money on your investments, although fixed-income annuities bear the risk of losing ground to inflation. If you are very comfortable with the stock market, you could consider a variable income annuity, the value of which fluctuates according to the performance of the annuity’s underlying mutual funds. You could also simply invest the money on your own, without an annuity.

2. Will your retirement income consist entirely or almost entirely of Social Security and withdrawals from your contemplated annuities? If resources available to invest for growth are small or nonexistent, inflation-adjusted annuities may be preferable to minimize the risk of losing out to inflation. Where other resources can be invested for growth, a fixed-income annuity might be preferable.

3. Are you, and if applicable, your spouse or partner, in good health? The better your health, the more desirable a lifetime annuity. Those in poorer health should usually opt for annuities with a minimum or fixed guaranteed payment period.

4. Have your ancestors lived long enough to make the Social Security Administration cringe? Long life expectancies bode well for the annuitant and bode ill for the insurance company.

5. If you are married, are you concerned about the possibility that years of nursing home expenses could impoverish the other spouse? If so, an annuity can provide a measure of protection for each spouse, since the annuity is not subject to forfeiture to pay nursing home or other care costs. Should other assets have to be spent down, a lifetime annuity will continue to pay for the remainder of the surviving spouse’s life.

Annuity Distribution Decision Maker

In terms of distribution, this Decision Maker will help you make another important and irreversible decision if you:

1. Have decided to purchase an annuity or are going to be receiving payments from a pension plan, and

2. Have a spouse who will need to be provided for financially, should you die before he or she does. Plans may also allow for non-spouse, contingent beneficiaries.

The decision involves which survivor option to take on your distributions. These typically include a range of choices, for example:

100 percent of the original benefit to the survivor for life

Two-thirds of the original benefit to the survivor for life

Half to the survivor for life

All to the annuitant for life, with nothing to the survivor

Payments over a specified period of time, rather than for life

Consider these questions:

1. Have you prepared budgets that reflect how the death of either of you would affect the survivor, financially speaking? The net effect of the loss of other income (for instance, Social Security) and the reduction in living expenses will help determine the amount of the annuity’s survivor benefit. Many couples find that a two-thirds benefit to the survivor fits the situation. But everyone’s financial situation is unique, so it’s important to do the number-crunching.

2. Have you factored your respective health histories into the distribution decision? While estimating life expectancy is fraught with hazard, the annuity distribution decision might change if there is a likelihood that the annuitant and/or the spouse will not reach a “normal” life expectancy. For example, if the annuitant is in poor health, a 100 percent benefit to survivor might be appropriate. On the other hand, if the spouse has a life-shortening health condition, a zero or low survivor benefit might be considered.

3. Have you compared the income you will receive under the various distribution options? It wouldn’t hurt to ask for distribution amounts under all available distribution alternatives. You may find that you’re not giving up much income to provide a greater benefit to a surviving spouse or partner. If that’s the case, you may want to opt for a more generous survivor benefit.

My employer informed us that the company is temporarily suspending the company matching funds for our 401(k) plan. They said they will start it back up in the future, but probably not this year. Because they aren’t matching funds, is it better to stop contributing to the 401(k) and contribute to a Roth IRA instead? Or should I still contribute? -Michael, Ohio

This question leaves me conflicted. Contributing to a Roth IRA is more financially advantageous than contributing to an unmatched 401(k) plan. But the advantages come later on, when you can enjoy tax-free withdrawals from your Roth IRA account. You have to be prepared to give up the tax breaks of contributing to a 401(k) plan.

Simply put, if you contribute to a Roth IRA in lieu of a 401(k)—matched or unmatched—your taxes this year will be higher. But over the long run, even factoring in the higher current-year taxes, the Roth IRA beats an unmatched 401(k).

My concern is that opting for a Roth IRA may cause you to give up on your 401(k) plan, even after your employer restores the match. As the economy rebounds and you become more confident about your financial future, I hope that you can get into a position of funding both your plan at work and a Roth IRA.

The stock market crisis has caused retirement savers to lose site of the surest way to build up the resources you’ll need for a financially comfortable retirement: saving regularly and regularly increasing the amount you save, no matter how badly the investment markets are faring. Ideally, this would involve contributing to more than one plan.

My financial adviser/broker recently changed employers. I now face the decision of staying with this individual and his new company or choosing a new company. How do I identify sound financial companies in light of the recent disasters of fraud, bad loans, buyouts etc.? –Robert, Iowa

This is a decision that many investors must face, given all the turmoil in the brokerage community. Here are some matters to consider:

The key to a successful relationship is the competence and responsiveness of your investment adviser, not his or her employer. So I wouldn’t recommend changing advisers solely based upon the brokerage firm getting into trouble or the adviser changing firms. On the other hand, if your adviser’s employer is in financial trouble, this may become a distraction for the adviser.

Keep in mind that some investment professionals jump ship because they are lured to another firm with fat bonuses. This would cause me a bit of concern lest the broker or adviser be under pressure to generate a lot of commissions to justify the signing bonus.

While the skills of your adviser are tantamount, you should also be comfortable with the new firm or the firm that your investment adviser now works for or uses to custody your investment holdings. With weekly revelations of investment chicanery, I think it is doubly important that your adviser work with a firm or custodian that is well-known and respected. It’s an additional comfort level during a very uncomfortable time for investors.

Finally, make sure you can and do periodically check on your holdings on the Internet. You should be able to go directly to the custodian’s Web site without your adviser’s assistance to make sure the statements you receive from your adviser are accurate.

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